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C H A PT E R 1 The Investment Environment 3 1

The average rate of return on investments in large stocks has outpaced that on investments inTreasury bills by about 77o since 1926.Why then, does anyone invest in Treasury bills?What are some advantages and disadvantages of top-down versus bottom-up investing styles?You see an advertisement for a book that claims to show how you can make $1 million with norisk and with no money down. Will you buy the book?

Why do financial assets show up as a component of household wealth, but not of nationalwealth? Why do financial assets still matter for the material well-being of an economy?Wall Street firms have traditionally compensated their traders with a share of the trading profitsthat they generated. How might this practice have affected traders' willingness to assume risk?What is the agency problem this practice engendered?

What reforms to the financial system might reduce its exposure to systemic risk?

Market Regulators

1. Go to the Securit ies and Exchange Commission Web site, www.sec.gov. What is themiss ion of the SEC? What in format ion and adv ice does the SEC of fer to beginn inginvestors?

2. Go to the FINRA Web site, www.f inra.org What is i ts mission? What informationand advice does i t offer to beginners?

3. Go to the IOSCO Web site, www.iosco.org. What is i ts mission? What informationand advice does i t offer to beginners?

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S*fw{i*yss t# CO v*1. a. Real

b. Financial

c. Real

d. Real

e. Financial

2. The central issue is the incentive to monitor the quality of loans when originated as well asover time. Freddie and Fannie clearly had incentive to monitor the quality of conforming loansthat they had guaranteed, and their ongoing relationships with mortgage originators gave themopportunities to evaluate track records over extended periods of time. In the subprime mortgagemarket, the ultimate investors in the securities (or the CDOs backed by those securities), whowere bearing the credit risk, should not have been willing to invest in loans with a disproportionatelikelihood of default. If they properly understood their exposure to default risk, then the(correspondingly low) prices they would have been willing to pay for these securities would haveimposed discipline on the mortgage originators and servicers. The fact thatthey were willing tohold such large positions in these risky securities suggests that they did not appreciate the extentof their exposure. Maybe they were led astray by overly optimistic projections for housing pricesor by biased assessments from the credit reporting agencies. In principle, either arrangementfor default risk could have provided the appropriate discipline on the mortgage originators; inpractice. however, the informational advantages of Freddie and Fannie probably made them thebetter "recipients" of default risk. The lesson is that information and transparency are some of thepreconditions for well-functioning markets.

s#F

PART I Introduct ion

nrgl{grn1. In what ways is preferred stock like long-term debt? In what ways is it like equity?

2. Why are money market securities sometimes referred to as "cash equivalents"?

3. Which of the following correctly describes a repurchase agreement?

a. The sale of a security with a commitment to repurchase the same security at a specified

future date and a designated price.

b. The sale of a security with a commitment to repurchase the same security at afuture date left

unspecif ied. at a designated price.

c. The purchase of a security with a commitment to purchase more of the same security at a

specified future date.

4. What would you expect to happen to the spread between yields on commercial paper and Treas-

ury bills if the economy were to enter a steep recession?

5. What are the key differences between common stock, preferred stock, and corporate bonds?

6. Why are high-tax-bracket investors more inclined to invest in municipal bonds than low-bracket

investors?.

{;1. ,'tutnback to Figure 2.3 andlook at the Treasury bond maturing in February 2039.

a. How much would you have to pay to purchase one of these notes?

b. What is its couponrate?c. What is the current yield of the note?

8. Suppose investors can earn a return of 27o per 6 months on a Treasury note with 6 months

remaining until maturity. What price would you expect a 6-month maturity Treasury bill to se11

for?

9. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at

year-end at $40, and receives a $4 year-end dividend. The firm is in the 307o tax bracket.

10. Turn to Figure 2.6 and look at the listin-e for General Dynamics.

rz. How many shares could you buy for $5,000?b. What would be your annual dividend income from those shares?c. What must be General Dynamics earnings per share?d. What was the firm's closing price on the day before the listing?

11. Consider the three stocks in the following table. P, represents price at trme t, and Q, represents

shares outstanding at time r. Stock C splits two for one in the last period.

QzQrP1QoPo

I ( A P L A N

A

B

C

9 54tr ,

5 5

a. Calculate the rate of return on a price-weighted index of the three stocks for the first perioc( r : 0 t o r : 1 ) .

b. What must happen to the divisor for the price-weighted index tnyear 2?

c. Calculate the rate of return for the second period (t : I to t : 2).

12. Using the data in the previous problem, calculate the first-period rates of return on the following

indexes of the three stocks:

a. A market-value-weighted index.b. An equally weighted index.

90

50

1 0 0

1 0 0

200

200

95

45

1 1 0

1 0 0

200

200

1 0 0

200

400

CHAPTE R 2 Asset Classes and Financial Instruments 59

-\rr irvestor is in a 307o tax bracket. If corporate bonds offer 97o yields, what must municipalsl.fier for the investor to prefer them to colporate bonds?

Find the equivalent taxable yield of a short-term municipal bond currently offering yields of 47oror tax brackets of zero, IjVo,207a, and307o.

\\hat problems would confront a mutual fund trying to create an index fund tied to an equallyx eighted index of a broad stock market?

\\l-rich security should sell at a greater price?

-;. A 10-year Treasury bgnd with a97o coupon rate versus a 10-year T:bond with a l\Vo coupon.:. A 3-month expiration call option with an exercise price of $40 versus a 3-month call on the

same stock with an exercise price of $35.--. A put option on a stock selling at $50, or a put option on another stock selling at $60 (al1

other relevant features of the stocks and options may be assumed to be identical).n ook at the futures listings for the coffi contract in Figure 2.8.

-;. Suppose you buy one contract for March delivery. If the contract closes in March at a levelof 3.875, what will your profit be?

i. How many March maturity contracts are outstanding?

Turn back to Figure 2J andlook at the Intel options. Suppose you buy a November expiration--all option with exercise price $21.

-:. Suppose the stock price in November is $21.75 Will you exercise your call? What is theprofit on your position?

:. What if you had bought the November call with exercise price $22?-'. What if you had bought a November put with exercise price $22?'t\h1'

do call options with exercise prices greater than the price of the underlying stock sell for:'-rsitive prices?

Both a call and a put currently are traded on stock XYZ; both have strike prices of $50 and::ipirations of 6 months. What will be the proflt to an investor who buys the call for $4 in the-ollowing scenarios for stock prices in 6 months? What will be the profit in each scenario to an-lvestor who buys the put for $6?

e. $60

Erplain the difference between a put option and a short position in a futures contract.

Erplain the difference between a call option and a long position in a futures contract.

-;. S40r. S45

c. $50d . b ) )

-{ tfrm's preferred stock often sells at yieids below its bonds because

-;. Prefered stock generally carries a higher agency rating.i. Owners of preferred stock have a prior claim on the firm's earnings.'. Owners of preferred stock have a prior claim on a firm's assets in the event of liquidation.:. Corporations owning stock may exclude from income taxes most of the dividend income

they receive.

-\ municipal bond carries a coupon of 63/q7o and is trading atpaL What is the equivalent taxabley. ield to a taxpayer in a combined federal plus state 347o tax bracket?

\\trich is the most rislcy transaction to undertake in the stock index option markets if the stocknarket is expected to increase substantially after the transaction is completed?

Cffi\goBLEMS

r. Write a call option.

b. Write a put option.c. Buy a call option.d. Buy a put option.

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CHAPTE R 3 How Secur i t ies Are Traded 9 1

Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from the

previous problem. The initial margin requirementwas 507o. (The margin account pays no inter-

est.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid

a dividend of $2 per share.

a. What is the remaining margin in the account?

b. If the maintenance margin requirementis 307o, will Old Economy receive a margin call?

c. What is the rate of return on the investment?

Consider the following limit-order book of a specialist. The last trade in the stock occurred at a

price of $50.

Limit Buy Orders Limit Sell Orders

Price Shares Price Shares

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q,/.q 75

49.50

49.25

49.00

48.50

500

800

500

200

600

$50 .2 s

5 1 . 5 0

54.75

58 .25

1 0 0'100

300

1 0 0

a.

b.L .

If a market buy order for 100 shares comes in, at what price will it be filled?

At what price would the next market buy order be filled?

If you were the specialist, would you want to increase or decrease your inventory of this

stock?

You are bullish on Telecom stock. The current market price is $50 per share, and you have

$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest

rate of 87o per year and invest $10,000 in the stock.

a. What will be your rate of return if the price of Telecom stock goes up by 107o during the

next year? The stock currently pays no dividends.

b. How far does the price of Telecom stock have to fa1l for you to get a margin call if the main-

tenance margin is 307o? Assume the price fall happens immediately.

You are bearish on Telecom and decide to sell short 100 shares at the current market price of

$50 per share.

a. How much in cash or securities must you put into your brokerage account if the broker's

initial margin requirementis 507o of the value of the short position?

b. How high can the price of the stock go before you get a margin call if the maintenance mar-

gin is 307o of the value of the short position?

Suppose that Intel curently is selling at $40 per share. You buy 500 shares using $15,000 of

your own money, borrowing the remainder of the purchase price from your broker. The rate on

the margin Ioanrs 87o.

a. What is the percentage increase in the net worth of your brokerage account if the price of

InteI immediately changes to: (i) $aa, (ii) $a0; (iii) $36? What is the relationship between

your percentage return and the percentage change in the price of Intel?

b. If the maintenance margin rs 257o, how low can Intel's price fall before you get a margin

ca l l ?c. How would your answer to (b) change if you had financed the initial"purchase with only

$10,000 of your own moneY?

d. Whatis the rate of return on your margined position (assuming again that you invest $15,000

of your own money) if Intel is selling after 1 year at (i) $aa, (ii) $40; (iii) $36? What is the

relationship between your percentage return and the percentage change in the price of Intel?

Assume that Intel pays no dividends'

e. Continue to assume that a year has passed. How low can Intel's price fall before you get a

marsin call?

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PART I Introduction

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12. Suppose that you sell short 500 shares ofIntel, currently selling for $40 per share, and give yourbroker $ 15,000 to establish your margin account.

a. If you earn no interest on the funds in your margin account, what will be your rate of returnafter 1 year if Intel stock is selling at: (i) $aa; (ii) $a0; (iii) $36? Assume thar Intel pays nodividends.

b. ii,ft. -.i"tenance margin is Z5Vo.how high can Intel's price rise before you get a margincall?

c. Redo parts (a) and (b), but now assume that Intel also has paid a year-end dividend of$l per share. The prices in part (a) should be interpreted as ex-dividend, that is. prices afterthe dividend has been paid.

Here is some price information on Marriott:

Bid Asked

Marriott 1 9 9 5 20 .05

You have placed a stop-loss order to sell at $20. What are you telling your broker? Given marketprices, will your order be executed?

14. Here is some price information on Fincorp stock. Suppose that Fincorp trades in a dealermarket.

Asked

55.25 5 5 .50

a. Suppose you have submitted an order to your broker to buy at market. At what price willyour trade be executed?

b. Suppose you have submitted an order to sell at market. At what price will your trade beexecuted?

c. Suppose you have submitted a limit order to sell at $55.62. What will happen?d. Suppose you have submitted a limit order to buy ar $55.37. What will happen?

Now reconsider the previous problem assuming that Fincorp sells in an exchange market likethe NYSE.

a. Is there any chance for the market buy order considered in part (a) to be executed at a pricebelow $55.50, and the sell order in part (b) at aprice above $55.25?

b. Is there any chance of an immediate trade at $55.37 for the limit-buy order in part (Q?

You've borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40 pershare. Your account starts at the initial margin requirement of 507o. The maintenance margin is357o.Two days later, the stock price falls to $35 per share.

a. Will you receive a margin call?b. How low can the price of Disney shares fall before you receive a margin call?

On January 1, you sold short one round lot (that is, 100 shares) of Lowes stock at $21 per share.On March 1, a dividend of $2 per share was paid. On April 1, you covered the short sale by buy-ing the stock at a price of $15 per share. You paid 50 cents per share in commissions for eachtransaction. What is the value of your account on April 1?

1. FBN, Inc., has just sold 100,000 shares in an initial public offering. The underwriter's explicitfees were $70,000. The offering price for the shares was $50, but immediately upon issue, theshare price jumped to $53.

a. What is your best guess as to rhe total cost to FBN of the equity issue?b. Is the entire cost of the underwriting a source of profit to the underwriters?

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Cfr\\-PIOBLEMS